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**Unformatted text preview: **nerating positive cash flows.
Comparing Equations 3.1 and 3.2 reveals that the key difference between the
accounting and finance definitions of operating cash flow is that the finance definition excludes interest as an operating flow, whereas the accounting definition
in effect includes it as an operating flow. In the unlikely case that a firm had no
interest expense, the accounting (Equation 3.1) and finance (Equation 3.2) definitions of operating cash flow would be the same. Free Cash Flow
free cash flow (FCF)
The amount of cash flow
available to investors (creditors
and owners) after the firm has
met all operating needs and paid
for investments in net fixed
assets and net current assets. The firm’s free cash flow (FCF) represents the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after the firm
has met all operating needs and paid for investments in net fixed assets and net
current assets. It represents the summation of the net amount of cash flow available to creditors and owners during the period. Free cash flow can be defined by
Equation 3.3.
FCF OCF Net fixed asset investment (NFAI)
Net current asset investment (NCAI) (3.3) The net fixed asset investment (NFAI) can be calculated as shown in Equation 3.4.
NFAI
EXAMPLE Change in net fixed assets Depreciation (3.4) Using the Baker Corporation’s balance sheets in Table 3.5, we see that its change
in net fixed assets between 2002 and 2003 was $200 ($1,200 in 2003 $1,000
in 2002). Substituting this value and the $100 of depreciation for 2003 into
Equation 3.4, we get Baker’s net fixed asset investment (NFAI) for 2003:
NFAI $200 $100 $300 Baker Corporation therefore invested a net $300,000 in fixed assets during 2003.
This amount would, of course, represent a net cash outflow to acquire fixed
assets during 2003. CHAPTER 3 Cash Flow and Financial Planning 107 Looking at Equation 3.4, we can see that if the depreciation during a year is less
than the decrease during that year in net fixed assets, the NFAI would be negative. A negative NFAI represents a net cash inflow attributable to the fact that the
firm sold more assets than it acquired during the year.
The net current asset investment (NCAI) represents the net investment made
by the firm in its current (operating) assets. “Net” refers to the difference
between current assets and spontaneous current liabilities, which typically
include accounts payable and accruals. Because they are a negotiated source of
short-term financing, notes payable are not included in the NCAI calculation.
Instead, they serve as a creditor claim on the firm’s free cash flow. Equation 3.5
shows the NCAI calculation.
NCAI EXAMPLE Change in current assets Change in spontaneous
current liabilities (Accounts payable Accruals) (3.5) Looking at the Baker Corporation’s balance sheets for 2002 and 2003 in Table
3.5, we see that the change in current assets between 2002 and 2003 is $100
($2,000 in 2003 $1,900 in 2002). The difference between Baker’s accounts
payable plus accruals of $800 in 2003 ($700 in accounts payable $100 in
accruals) and of $700 in 2002 ($500 in accounts payable $200 in accruals) is
$100 ($800 in 2003 $700 in 2002). Substituting into Equation 3.5 the
change in current assets and the change in the sum of accounts payable plus
accruals for Baker Corporation, we get its 2003 NCAI:
NCAI $100 $100 $0 This means that during 2003 Baker Corporation made no investment ($0) in its
current assets net of spontaneous current liabilities.
Now we can substitute Baker Corporation’s 2003 operating cash flow (OCF)
of $350, its net fixed asset investment (NFAI) of $300, and its net current asset
investment (NCAI) of $0 into Equation 3.3 to find its free cash flow (FCF):
FCF $350 $300 $0 $50 We can see that during 2003 Baker generated $50,000 of free cash flow, which it
can use to pay its investors—creditors (payment of interest) and owners (payment of dividends). Thus, the firm generated adequate cash flow to cover all of
its operating costs and investments and had free cash flow available to pay
investors.
Further analysis of free cash flow is beyond the scope of this initial introduction to cash flow. Clearly, cash flow is the lifeblood of the firm. We next consider
various aspects of financial planning for cash flow and profit. Review Questions
3–1 3–2 Briefly describe the first four modified accelerated cost recovery system
(MACRS) property classes and recovery periods. Explain how the depreciation percentages are determined by using the MACRS recovery
periods.
Describe the overall cash flow through the firm in terms of operating
flows, investments flows, and financing flows. 108 PART 1 Introduction to Managerial Finance 3–3 3–4
3–5
3–6 LG3 Explain why a decrease in cash is classified as a cash inflow (source) and
why an increase in cash is classified as a cash outflow (use) in preparing
the statement of cash flows.
Why is depreciation (as well as amortization and depletion) considered a
noncash cha...

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